There are two personal finance topics that I have been wanting to look at more closely:
personal portfolio allocation and wealth accumulation during your working years, and
personal portfolio allocation and distributions during your retirement years.
This article is focused on the first topic.
My view is that accumulating wealth during your decades of working years has less to do with stock or bond selection, and more to do with two other things:
Having the most aggressive allocation of your savings across asset types that your personal risk tolerance permits, and
Staying the course on a strategy in good times and bad, with minor tweaks permitted.
The data and choice of asset classes
I have gathered some historical return data to look at how various portfolios have performed on a hypothetical basis over time based on asset allocation. The data is focused on US assets only since this is the market in which there is the most readily-available data. In addition, I have looked at only five asset classes although there are many others, including the growing world of private / illiquid investments (e.g. private equity, private credit, and “passion assets”). I have also focused on a relatively short 32 year period – 1991 to 2023YtD – since this is the period for which I was able to gather all of the requisite data I needed to put the model together:
S&P 500 total return index
7y-10y US Treasury total return index
BBB corporate bond total return index
US high yield bond total return index
Yield on 30 day US Treasury bills (as a proxy for cash)
The data came from a combination of Morningstar Direct (SBBI data from Ibbotson, here from CFA Institute website but need to be a member) and ICE BofA corporate bond indices available on FRED Economic Data. I have looked at returns on an annual basis, using closing index prices at the end of each year.
The table below shows performance metrics on the five asset classes mentioned above, including compound average annual return, arithmetic average of annual return, standard deviation (a measure of risk), the worst return and year, and the best return and year. This is for the period 1991 to 2023YtD.
Over a much longer period of time and using slightly different data (i.e. all from Morningstar / Ibbotson), the returns graphically look like this:
None of the performance data is surprising to me aside from the fact that the BBB bond index in the table has lower risk (as measured by standard deviation) than intermediate term (7y-10y) US Treasury notes. I suppose this reflects the fact that BBB corporate bonds have a credit spread to “absorb” some of the volatility in underlying US Treasuries, which can be whipsawed one way or the other as market forces cause yields to increase and decrease. Keep in mind also that US Treasuries and UST bills (cash proxy) have no credit risk, but the former expose investors to significant duration risk as yields change prior to the maturity of the bond(s).
Portfolio construction
Guessing when to buy and sell various financial assets is a fool’s game at the end of the day, because in the long-run the chances are near certain that you will get many decisions wrong. Adjusting “around the edges” is a different matter altogether, appropriate in my opinion depending on the macroeconomic outlook. This means two things:
Tilting (meaning slightly adjusting) your portfolio towards less risk when market excesses suggest bubbles, or more risk when everyone is running the same direction due to panic (that does not appear supported by long-term fundamentals), and
Drilling down into indices to gain (or reduce) exposure to select sectors or countries subject to cycles or changes in your own risk-appetite.
Jumping in and out of markets regularly can deliver some good results and bad, but as I have written about before in EMC (see “Stocks – do they always go up?”), staying the course will almost certainly deliver the best results over long periods of time.
I have looked at 15 different scenarios in the table below, divided into five sections:
Mix of stocks and US Treasuries (four scenarios)
Mix of stocks, US Treasuries and investment grade rated (BBB) corporate bonds (three scenarios)
Mix of stocks, US Treasuries, and both investment grade and high yield bonds (three scenarios)
Balanced portfolio including a component of cash (three scenarios)
Conservative portfolio featuring little or no stock exposure and more cash (two scenarios)
The conclusion is relatively straight-forward in that – unsurprisingly – the more your portfolio is oriented towards stocks, the better the return although these portfolios are also the most volatile as measured by standard deviation and the high-low return range. Aside from this, the performance data is largely as might be expected – more cash and bonds reduce both the risk and the return.
I added the conservative portfolios as the last two to illustrate that risk can be slashed significantly by skewing your portfolio towards cash and Treasuries, but returns fall sharply, too. For extremely risk-adverse investors, one of these asset mixes might enable you to sleep better at night because your portfolio will not be subject to as wide of swings in annual returns as those portfolios with more risk. However, be aware that the difference in wealth accumulation over long periods of time become very substantial. As the table illustrates, a stock-bond (UST) mix of 80-20 generates three times the wealth over time compared to a portfolio with only USTs, BBB bonds and cash. This is a very dear price to pay in terms of accumulating a “pot of gold” although risk tolerance is a personal decision.
Another interesting thing to note that is not apparent in the table above is that there were difficult periods where the portfolio mix mattered little as far as losses if you had exposure to equities or bonds.
2008 and 2022 were two of the worst years, when returns of stocks and bonds were positively correlated and badly negative.
The three years following the dot.com bubble period (2000-2002) were also difficult, albeit not as dire as the pre-GFC and post-pandemic periods when the Fed was tightening monetary policy.
At the other extreme, very strong years of performance largely independent of portfolio mix occurred in 1995, and – perhaps not surprisingly – the year in each case following three separate crises: 1991 (which followed the 1990 recession), 2010 (which followed the GFC) and 2021 (which followed the early stages of the pandemic).
Watching your portfolio shrink in value can be un-nerving to say the least, but believing that such deterioration is temporary can make it slightly more tolerable. It’s one thing to lose money one year, but what about two or three years in a row, similar to what occurred in the 2000-2002 period? I looked at two of the scenarios in the table above to see during how many consecutive three-, five- and 10-year periods had negative performance.
Recalling that returns are three times greater over the period in the first scenario (80/20) vs the second (mostly bonds and cash), if you are one that has difficultly tolerating losses, then the more conservative second scenario never has three-, five- or 10-year periods over which the return is negative. Although losses in a given year might make you queasy, this mix should allow you to sleep at night because the negative returns are more quickly overcome.
So what about now?
We are currently in an environment in which short-term rates are higher than they have been since 2007, representing an opportunity to earn nice returns on less-than-one-year risk-free investments (UST bills) and take no duration risk. Disinflation is finally occurring, and this means the risk of “higher for longer” is probably easing. As we have seen in November, lower expected yields equate to a growing “risk on” sentiment. However, even though long-term yields are starting to ease, short-term yields remain elevated as they have been for some time. I have concerns that the effect of the Fed’s tightening have yet to fully reverberate through the economy. Therefore, my view is that the US economy will slow rather sharply in the coming months, which I recognise is no longer a majority view. Nonetheless, this view shapes my strategy, which means a tilt towards less cyclical companies / sectors for equities and higher rated corporate bonds.
This diatribe might sound as if it goes against my mantra of “staying the course”, but it does not. Rather, it suggests subtle moves, ones which I have been making now for several months in order to capitalise on high short-term yields and to tilt my equity portfolio slightly towards a more defensive posture. Given the strong performance of traditional asset classes in November, my slight adjustments might prove premature. We shall see.
As an aside, the one asset class I have not owned and am unlikely to own is US Treasuries with maturities of more than one year. My preferred choice for fixed-income investments is corporate bonds (via ETFs), for reasons that the tables in this article reveal. (In case you are interested, I provided many attributes of my personal portfolio in EMC in a recent article here.)
Conclusion
Although I sound like a broken record, my advice – and the younger you are the better although it’s never too late – is simple and consistent with a number of other articles I have written:
Skew your portfolio towards equities, which over a long period of time have demonstrated the highest returns of traditional assets classes,
Use low cost index funds as investment vehicles unless you are perfectly willing to enjoy the challenge of investing in individual stocks but recognise that your chance of outperforming the market is almost nil over any reasonable period,
Stay the course – limit large variations and spur-of-the-minute decisions to materially alter portfolio allocations; limit your “in and out” decisions,
Dollar-cost average by investing regularly whether markets are up or down, and reinvesting your dividends,
Think in decades or years, certainly not in months, weeks, days or hours,
Recognise and embrace diversification across asset classes in line with your risk tolerance, and by company, sector or country within asset classes, and
Learn to look at occasional market dislocations as an opportunity to invest, not a reason to panic.
That’s as simple as it gets for me because the data speaks for itself.
Comentários